Naked short selling is when an investor essentially shorts a stock that he hasn’t actually borrowed. During the worst of the financial crisis some corporate executives blamed the tactic for their companies’ plunging stock prices. In the U.S., regulators put new temporary rules in place to curb the practice in the fall of 2008. That rule was made permanent in July 2009.
As more details of last Thursday's collapse become clear, there is less evidence to suggest a "fat-finger" data-entry error caused the collapse. Instead, the picture is one of a highly rare confluence of events, some linked, some unrelated, that exposed weaknesses in the stock market large and small. Within five minutes, the Dow Jones Industrial Average had lost 700 points as trading seized up in individual stocks such as Procter & Gamble and even exchange-traded mutual funds.
"It did point out that there is a structural flaw," said Gus Sauter, chief investment officer at Vanguard Group. "We have to think through how you preserve the immediacy and yet preserve the liquidity."
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This diversity has made stock-trading cheaper, a plus for both institutional and individual investors. It has also made it more unruly and difficult to ensure an orderly market...
“There are a whole other group of folks who play this game,” Mr. Tabb said. “They put low limit orders into the market for this exact purpose — for when the markets go into free fall.”
...Unfortunately for those investors, the exchanges have rules in place to cancel or rescind any trades that are associated with erroneous or unusual trading activity.
“If there is an order that gets printed and it is so far away from the market that it was clearly wrong, the exchanges have the right to break it and, in fact, they do it fairly often,” Mr. Tabb said. “It just doesn’t happen with this magnitude.”
On Friday, the Nasdaq market said it would cancel all trades that had occurred in the 20-minute period between 2:40 p.m. and 3 p.m. on Thursday that were 60 percent higher or lower than the last trade at 2:40. “This decision,” the exchange noted on its Web site, “cannot be appealed.”
We are proposing to require the filing of a computer program (the “waterfall computer program,” as defined in the proposed rule) of the contractual cash flow provisions of the securities in the form of downloadable source code in Python, a commonly used computer programming language that is open source and interpretive. The computer program would be tagged in XML and required to be filed with the Commission as an exhibit. Under our proposal, the filed source code for the computer program, when downloaded and run (by loading it into an open “Python” session on the investor’s computer), would be required to allow the user to programmatically input information from the asset data file that we are proposing to require as described above. We believe that, with the waterfall computer program and the asset data file, investors would be better able to conduct their own evaluations of ABS and may be less likely to be dependent on the opinions of credit rating agencies.
Hmmm.... sounds like the SEC want's unit tests the users can run. I guess they don't trust the ratings agencies.
About 4,000 trades were broken on Thursday after being identified as clearly erroneous as per exchange rules, Mr. Niederauer said, and the wild fluctuations were certain to prompt more scrutiny of high-frequency trading from regulators.
"We as an industry have to say how much is too much of this technology," Mr. Niederauer said.
A number of high-frequency firms closing down in the midst of a sharp market drop can "widen markets out substantially," said Jamie Selway, managing director of New York broker White Cap Trading.
High-frequency firms have in recent years become central to how the market operates, growing to account for about two-thirds of daily market volume, according to industry estimates.
The firms use high-powered computers to send "buy" and "sell" orders to the market at rapid speeds. High-frequency traders have said part of the value they add to markets is the liquidity they bring—being at the ready to swiftly complete a trade. Some of these firms have said that, were it not for them, the 2008 market declines would have been worse.
According to multiple sources, a trader entered a "b" for billion instead of an "m" for million in a trade possibly involving Procter & Gamble [PG 60.75 -1.41 (-2.27%) ], a component in the Dow. (CNBC's Jim Cramer noted suspicious price movement in P&G stock on air during the height of the market selloff..)
Sources tell CNBC the firm in question that handled the erroneous trade is Citigroup [C 4.04 -0.14 (-3.35%) ]. The bank said it has no evidence of a bad trade but is investigating the situation
